Category: Choice of entity – federal income tax

Every LLC lawyer will agree that the most important threshold task in forming LLCs is a task often referred to as “choice of entity.” In the months and years to come, this blog will address dozens of choice-of entity issues.

But the key fact you have to realize before you undertake any choice-of-entity analysis is that there is, technically, no such thing. Rather, choice of entity requires three types of analyses, each of which is entirely different from the others. When you’re doing choice-of-entity, you should, to the extent of your competence, do all three analyses and then, if there are any conflicts among them, reconcile these conflicts.

To explain:

Non-tax choice of entity. The first type of choice-of-entity analysis is non-tax choice of entity. This is the process by which lawyers choose the best type of business organization for their clients on non-tax grounds—mainly on business organization law grounds. The key types of business organizations are sole proprietorships, divisions, general partnerships, limited partnerships, corporations and LLCs. The key issues are, for most clients, (1) Does the client need a liability shield? (2) If so, which type of organization will provide the client with the best shield? (3) Does the client need the special statutory business asset protections referred to by LLC lawyers as charging order protections? (4) If so, should the client obtain these protections through a general partnership, a limited partnership or an LLC? (Most corporate statutes don’t provide charging order protections.)

Choosing the right federal income tax regimen for federal income tax purposes. The second is choice of federal income tax regimen for federal income tax purposes. The relevant regimens are disregarded entity taxation and Subchapters C, K and S. Key issues include: (1) Which regimen will provide the client with the lowest tax rate? (2) Which will provide the client with the greatest flexibility in deploying and redeploying business assets?

Choosing the right federal income tax regimen for Social Security Tax purposes. The third is choice of federal income tax regimen for Social Security Tax purposes. The relevant regimens are those listed above, but the relevant issues are entirely different from federal income tax issues. In addition, you won’t find the key authority in this field in the Internal Revenue Code or even in a final regulation—it’s a little-known but remarkably powerful IRS proposed regulation designated Prop. Reg. § 1.1402(a)-2.

Understanding these three types of analyses in detail takes a lot of study and experience; but the best place to start in understanding them is with the Big Picture. The Big Picture is in the three bullet points above.

On April 27, 2010, I taught a 90-minute national teleconference CLE-credit seminar for National Business Institute on the basics of LLC taxation. In my experience, for most single-member LLCs whose members are individuals, the two federal income tax regimens that are likely to be useful are sole proprietorship taxation and Subchapter S; and for almost all multi-member LLCs, the relevant federal income tax regimens are Subchapter K (partnership taxation) and Subchapter S. My seminar was based in part on tables I’ve prepared comparing the above regimens. If tax choice of entity is a topic that interests you, you can access the table comparing sole proprietorship taxation and Subchapter S, click here; and you can access the table comparing Subchapter K and Subchapter S by clicking here.